Global Strategy Flash Weekly Cross Asset Views Deutsche Bank Markets Research

Global Strategy Flash Weekly Cross Asset Views Deutsche Bank Markets Research

Deutsche Bank
Markets Research
Global
Australia
Canada
United States
Cross-Discipline
Date
4 November 2014
Dominic Konstam
Global Strategy Flash
Research Analyst
(+1) 212 250-9753
dominic.konstam@db.com
Weekly Cross Asset Views
Joseph LaVorgna
Trade recommendations
USD: Sell 6M 5Y5Y strangles vs. 6M5Y straddles.
USD: Bullish on S&P, contingent on US rates (contingent call).
USD: Bearish on EUR, contingent on US rates (dual digital option).
U.S. Economics
We are projecting +220k gains in both ADP and private payrolls, and +225k in
headline nonfarm payrolls. We highlight the strong correlation between nonmanufacturing ISM survey and job growth, with the former pointing to a
meaningful upshift in job gains in coming quarters.
U.S. Rates
All eyes are trained on the ECB. We think the most likely scenario is that
Draghi recognizes concerns regarding current policy tools and perhaps
downplays them but pre-commits to other measures if necessary including
corporate bond buying, more attractive TLTRO conditions etc. There are still
many uncertainties around, for example, a corporate bond purchase program.
Some caution on the market’s reaction to this scenario might still be in order
due to these uncertainties. Better to chase than to be side swiped, in our view.
Japan Rates
The BOJ’s increased pace of monetary base expansion and increased ETF
purchases are likely to be further catalysts for yen depreciation and a rise in
stocks, which should put upside pressure on swap rates. We expect this to
result in JGBs outperforming in the super-long sector compared to swaps.
Chief US Economist
(+1) 212 250-7329
joseph.lavorgna@db.com
Makoto Yamashita, CMA
Strategist
(+81) 3 5156-6622
makoto.yamashita@db.com
Francis Yared
Strategist
(+44) 020 754-54017
francis.yared@db.com
Steve Abrahams
Research Analyst
(+1) 212 250-3125
steven.abrahams@db.com
David Bianco
Strategist
(+1 ) 212 250-8169
david.bianco@db.com
Agencies
Federal Home Loan Banks will lead the market growth in 2015 as Fannie and
Freddie shrink their debt by another 10%. The GSE market should enter a
phase of renewed expansion starting in 2016. On the agency curve, we find
the 2y sector has the best relative value after adjusted for spread risk.
U.S. Credit
Value has returned back to lower quality parts of the HY market (low single-Bs
and CCCs), especially those between 2-4 years of duration, as well as to the
10-year segment in non-financial IG corporate paper.
Mortgages
As long as the Fed keeps holding an outsized share, MBS stands to keep
rolling up good performance. We don’t expect any tapering in the Fed’s
reinvestment before 2016, and therefore, the demand for MBS is likely to be
good enough to absorb net supply if it remains at 2014 levels.
________________________________________________________________________________________________________________
Deutsche Bank Securities Inc.
DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MCI (P) 148/04/2014.
4 November 2014
Global Strategy Flash: Weekly Cross Asset Views
U.S. Economics
Even though the financial markets are bracing for Friday’s October
employment report, today’s economic data are significant, because they, too,
will provide us with important information on the state of the labor market and
the broader economy. With respect to the ADP survey, we need to compare its
initial value versus the initial reading on private payrolls. Over the last 12
months, the average absolute difference between the two series is a relatively
small 44k. As an aside, private payrolls have tended to be revised higher—they
have been revised up 11 out of the last 12 months by an average of 30k. We
are projecting +220k gains in both ADP and private payrolls (headline nonfarm
payrolls is estimated at +225k), and we will revisit our forecast if there is an
outlier reading on ADP.
The non-manufacturing ISM survey will also attract some attention because
the employment subcomponent is another leading indicator of the labor
market, and it also tends to be highly correlated with job growth. We expect
the non-manufacturing ISM to remain at an elevated level in October based on
the strength in the Richmond Fed services survey. If the non-manufacturing
ISM employment subcomponent remains elevated, it would strongly suggest
that the pace of jobs gains is on the cusp of a meaningful upshift. As shown in
the chart below, the non-manufacturing ISM employment series averaged 57.2
in Q3, which ties the historical high from Q1 2005. This would also be
consistent with the recent cyclical low in jobless claims. Given the relationship
with ADP employment shown below, history suggests we should see faster job
growth in the quarters ahead.
Initial jobless claims recently pierced the 300k level to the downside. The
current four-week moving average on claims is +281k, which is the lowest
level in 14 years. If the recent downtrend in claims continues, payroll gains
could accelerate to 250k-plus over the coming months. At that pace of job
creation, the unemployment rate would be on track to breach 5% by the end of
next year. In short, a number of labor market indicators are pointing to a
healthier job market. Hopefully, this will be confirmed by Friday’s data.
Regarding revisions to GDP, a wider international trade deficit and slightly less
inventory accumulation than what the Bureau of Economic Analysis had
previously assumed mean Q3 output is now tracking at 2.9% compared to its
initial 3.5% reading. Next week’s retail sales and business inventory data will
provide us with more information on Q3 revisions and the state of current
quarter output growth, which we presently project at 4.2%.
ISM employment index vs. ADP nonfarm employment
Source: Deutsche Bank
Joseph Lavorgna and Carl Riccadonna
(+1) 212 250-7329/0186
Joseph.lavorgna@db.com,carl.riccadonna@db.com
Page 2
Deutsche Bank Securities Inc.
4 November 2014
Global Strategy Flash: Weekly Cross Asset Views
U.S. Rates
There is a lot of optimism that Draghi “will deliver”. There is less clarity as to
exactly how he will do that. Moreover the front running of the Euro currency
weakness relative to balance sheet emphasizes the vulnerability to any sense
of back sliding on balance sheet growth.
We would roughly think of three possible outcomes with the middle one the
most likely, in that it keeps the balls in the air. The most negative outcome for
risk is that Draghi simply reiterates what they have already committed to,
without recognizing possible limitations that the market is aware of, including
TLTRO take ups and ABS+covered bond purchases. The middle, more likely
scenario, is that Draghi recognizes these concerns, perhaps downplays them
but pre-commits to other measures if necessary including corporate bond
buying, more attractive TLTRO conditions etc. The third most bullish scenario
would be a more brazen commitment to sovereign QE. This is not likely in our
view at this stage – although many investors believe it is inevitable for the end
game and the only debate is whether it takes a German recession or risk off
phase to achieve it. For now though we do not think it is necessary for
sustaining the recent risk asset gains. Even in the middle scenario there are
still many uncertainties around say a corporate bond program in terms of the
skew towards specific issuers so as ever, assuming we go into the ECB, with
elevated risk assets some caution on subsequent market reaction might still be
in order. Better to chase than to be side swiped, in our view.
It is important to appreciate why the dynamic of the stronger dollar and
weaker oil potentially improves the economic outlook. When domestic demand
(assets) are in danger of staying (becoming) weak due to disin(de)flation woes,
a stronger dollar only imports into the US extra deflation. Weak oil may
improve household balance sheets but if that “shadow” income is saved, it
won’t be worth much for growth. If global demand is stronger, then a stronger
dollar instead of importing deflation instead, relatively speaking, exports
inflation. The difference is important. The former risks the Fed having to have
additional accommodation at home; the latter allows the Fed to delay
tightening. To repeat: one makes you worried about bull steepening with more
emphasis on the bull, the other makes you embrace bull flattening, with more
emphasis on the flattening.
Trade Recommendations

Sell $115mn 6M 5Y5Y 14bp wide mid-curve strangles vs. buy $100mn
6M5Y vanilla straddles at zero next cost.

Sell $70mn 6M 5Y5Y 20bp wide mid-curve strangles vs. buy $100mn
6M3Y vanilla straddles at zero next cost.

Buy 3M SPX 102.5% call subject to 5Y CMS < ATMF – 10bp, offer 0.64%,
a 55% discount to vanilla at 1.43%.

3M Dual Digital US 5Y CMS < ATMF – 10bp & EURUSD < 1.2250,
offer12.1%, an 8.3:1 leverage.
Dominic Konstam and team
(+1) 212 250-9763
dominic.konstam@db.com
Deutsche Bank Securities Inc.
Page 3
4 November 2014
Global Strategy Flash: Weekly Cross Asset Views
Japan Rates
JGB yields curve massively bull-flattened after the BOJ’s additional monetary
easing on last Friday. The BOJ decided to accelerate a JPY10- 20 trillion on in
the annual pace of monetary base expansion and a JPY30 trillion increase in
the amount by which the central bank aims to increase its JGB holdings each
year. The BOJ is also expected to double its allocations to the super-long
sector—where it still absorbs a comparatively small percentage of issuance—
from 3Q 2014 levels which dampen the yield more than 10y- sector. The BOJ’s
increased pace of monetary base expansion and increased ETF purchases are
likely to be further catalysts for yen depreciation and a rise in stocks, which
should put upside pressure on swap rates. We expect this to result in JGBs
outperforming in the super-long sector compared to swaps.
The GPIF (Total asset is 127trn yen as of June) also formally announced a new
allocation ratio last Friday. It will lower JGB holdings to 35% of its portfolio
(from the current basic weighting of 60%) and raise domestic stocks to 25%
(12%), foreign bonds to 15% (11%), and foreign stocks to 25% (12%). We
estimate the decrease of GPIF's JGB holdings could be around 20trn yen.
However, this change would just moderate tight JGB supply/demand balance,
as the BoJ has ramped up its JGB purchases by JPY30trn.
Makoto Yamashita
(+81) 35156 6622
makoto.yamashita@db.com
Agencies
As we prepare our 2015 agency market projections, three things stand out to
us and are worth highlighting. First, the Federal Home Loan Banks will
increase their lead in market issuance over the other participants during next
year, and their total debt will for the first time surpass Fannie’s and Freddie’s
combined. Second, Fannie and Freddie may begin to slow their pace of
winding down given that their debt is already comfortably sitting 20% below
the PSPA threshold for 2015. This should on the margin be positive (or less
negative) for market liquidity. Finally, in 2015 the agency market will undergo
its final year of contraction of around -1%. Under even conservative growth
estimates, the agency market will begin expanding again in 2016 and beyond.
Updating our recommendation from last week, we continue to see good value
in the front-end, especially the 2y sector. On a one-year history, 2y and 3y
spreads are 1.7 standard deviations wide and 1.9 standard deviations wide to
their average respectively. However, after adjusting for spread volatility, 2y has
the best return/risk ratio compared to rest of the curve.
Steven Zeng
(+1) 212 250 9373
steven.zeng@db.com
U.S. Credit
BBs are 50bps wider since Jun 30th, while CCCs are 210bp wider. Now the
normal historical spread betas are 0.8x and 1.5x respectively, so all else being
equal, one would expect BBs to be 70bps wider and CCCs 135bp wider at the
time when overall HY is +90bp. Not all else is equal however, as we have
highlighted on a number of occasions the tightness of lower quality segments
since early July. So we view this underperformance as a necessary part of
readjustment in valuations that needed to have taken place. At their current
Page 4
Deutsche Bank Securities Inc.
4 November 2014
Global Strategy Flash: Weekly Cross Asset Views
levels, we believe CCCs and low single-Bs, especially those inside of 4yr
durations, are beginning to look attractive for the first time in months. Within
IG, the 10-year segment stands out to us as a sector for value across As and
BBBs; high-quality front-end paper has cheapened up from 5th percentile
levels but remains the least attractive on a relative valuation basis.
Oleg Melentyev and Daniel Sorid
(+1) 212 250-6779/1407
oleg.melentyev@db.com, daniel.sorid@db.com
Mortgages
Such sweet sorrow
With the Fed announcing an end to QE last Wednesday, the MBS market
enters a new phase where a third of outstanding securities remain out of reach
for private hands and where no government portfolio drives marginal pricing.
As long as the Fed keeps holding an outsized share, MBS stands to keep
rolling up good performance. But the real risks get put off until that share
starts to fall.
The $1.7 trillion in Fed MBS leaves the rest of the market to shop in the
remaining $3.5 trillion for meeting regulatory liquidity ratios, holding as margin
against derivatives transactions, managing against US and global market index
allocations, covering liabilities and other purposes. Demand is likely to be good
enough to absorb net supply if it remains at 2014 levels.
The Fed holdings also keep a source of volatility out of private hands. Even
though the Fed holds a third of outstanding, through July the Fed held roughly
half of outstanding MBS dollar duration – the Fed generally owning the part of
the MBS market with the longest duration. This clearly keeps MBS duration
out of the increasingly few hands that explicitly hedge it, primarily the
managers of Federal Home Loan Bank portfolios and those managing the
dwindling positions at Fannie Mae and Freddie Mac. More importantly, it
keeps the duration off of the balance sheets of banks, insurers, pensions and
other places where change in MBS duration often forces another parts of the
balance sheet to compensate. As a result, broad market volatility should run
lower than it would otherwise.
Eventually Fed reinvestment of MBS principal should evolve into a dynamic of
its own since any tapering of reinvestment could become a major supply of net
MBS to the private market. That will put the spotlight on private market pricing
of MBS and should start to lift volatility. However, any tapering in reinvestment
is likely an early 2016 event at the earliest, and the process could stretch
through 2017. Fed Chair Yellen said after the last FOMC that the committee
would defer any tapering until it was comfortable with the impact of higher
short rates and the outlook for inflation and employment. Given the
complexities of its tools – interest on excess reserves, overnight reverse repo
and effective fed funds – and the heightened risk of slowing the economy with
rates near the zero bound, the Fed will likely proceed slowly unless the
economy strengthens a lot faster than it has lately.
The end of the Fed as a net buyer does hand the baton for marginal pricing to
the private market. This will be the first time that the market will price without
a bid from a growing Fannie Mae or Freddie Mac portfolio, where balances
peaked in early 2009, or from the US Treasury or Federal Reserve. With the
exception of the period between QE1 and QE3, a bid from at least one of these
parties has been in the market since the early 1990s. This transition puts the
market into hands with more expensive capital, less leverage or both. We
should probably get good marginal demand from money managers as that
Deutsche Bank Securities Inc.
Page 5
4 November 2014
Global Strategy Flash: Weekly Cross Asset Views
sector reallocates from underweight MBS toward neutral. But as more and
more of the MBS market sits over time on private balance sheets, spreads, all
else equal, have to go wider.
So, the supply/demand equation now changes. It was net Fed demand against
net primary market supply. As QE ends, it becomes net private demand against
new primary supply and, eventually, net secondary supply from the Fed. We’re
in the sweet spot now after QE but before any tapering in reinvestment. Enjoy
it while it lasts.
Steve Abrahams and Ian Carow
(+1) 212 250-3125/9370
steve.abrahams@db.com, Ian.carow@db.com
Page 6
Deutsche Bank Securities Inc.
4 November 2014
Global Strategy Flash: Weekly Cross Asset Views
Appendix 1
Important Disclosures
Additional information available upon request
For disclosures pertaining to recommendations or estimates made on securities other than the primary subject of this
research, please see the most recently published company report or visit our global disclosure look-up page on our
website at http://gm.db.com/ger/disclosure/DisclosureDirectory.eqsr
Analyst Certification
The views expressed in this report accurately reflect the personal views of the undersigned lead analyst(s). In addition,
the undersigned lead analyst(s) has not and will not receive any compensation for providing a specific recommendation
or view in this report. Dominic Konstam
Deutsche Bank Securities Inc.
Page 7
4 November 2014
Global Strategy Flash: Weekly Cross Asset Views
(a) Regulatory Disclosures
(b) 1. Important Additional Conflict Disclosures
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(c) 2. Short-Term Trade Ideas
Deutsche Bank equity research analysts sometimes have shorter-term trade ideas (known as SOLAR ideas) that are
consistent or inconsistent with Deutsche Bank's existing longer term ratings. These trade ideas can be found at the
SOLAR link at http://gm.db.com.
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meaning of the Australian Corporations Act and New Zealand Financial Advisors Act respectively.
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its(their) securities, including in relation to Deutsche Bank. The compensation of the equity research analyst(s) is
indirectly affected by revenues deriving from the business and financial transactions of Deutsche Bank. In cases where
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preparation of this research report, the Brazil based analyst whose name appears first assumes primary responsibility for
its content from a Brazilian regulatory perspective and for its compliance with CVM Instruction # 483.
EU
countries:
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our
obligations
under
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Page 8
Deutsche Bank Securities Inc.
4 November 2014
Global Strategy Flash: Weekly Cross Asset Views
(g) Risks to Fixed Income Positions
Macroeconomic fluctuations often account for most of the risks associated with exposures to instruments that promise
to pay fixed or variable interest rates. For an investor that is long fixed rate instruments (thus receiving these cash
flows), increases in interest rates naturally lift the discount factors applied to the expected cash flows and thus cause a
loss. The longer the maturity of a certain cash flow and the higher the move in the discount factor, the higher will be the
loss. Upside surprises in inflation, fiscal funding needs, and FX depreciation rates are among the most common adverse
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convertibility (which may constrain currency conversion, repatriation of profits and/or the liquidation of positions), and
settlement issues related to local clearing houses are also important risk factors to be considered. The sensitivity of fixed
income instruments to macroeconomic shocks may be mitigated by indexing the contracted cash flows to inflation, to
FX depreciation, or to specified interest rates - these are common in emerging markets. It is important to note that the
index fixings may -- by construction -- lag or mis-measure the actual move in the underlying variables they are intended
to track. The choice of the proper fixing (or metric) is particularly important in swaps markets, where floating coupon
rates (i.e., coupons indexed to a typically short-dated interest rate reference index) are exchanged for fixed coupons. It is
also important to acknowledge that funding in a currency that differs from the currency in which the coupons to be
received are denominated carries FX risk. Naturally, options on swaps (swaptions) also bear the risks typical to options
in addition to the risks related to rates movements.
Deutsche Bank Securities Inc.
Page 9
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